Repayment obligations to creditors and investors during times of liquidity due to bankruptcy follow a hierarchy. Senior debts, which include senior bonds, have a higher priority claim on the assets of a particular dissolving entity over other securities and instruments. These bonds sit atop subordinated bonds and well above preferred stocks and common stocks.
The fact that senior bonds exist means that not all bonds are created and treated equally. There are different types of bonds, and some are categorized according to the level of risks that come with holding them and their position on the hierarchy of claims. This article discusses the pros and cons or advantages and disadvantages of investing in senior bonds.
Pros: Advantages of Senior Bonds
Bankruptcy would force an entity to settle its obligations to its creditors and investors. However, because of its poor financial standing, and in case of bankruptcy protection, its repayment capabilities are limited. Not all creditors and investors would be repaid. Senior bonds have the highest priority claim over other bonds and even stocks.
Hence, considering the aforesaid advantage, it also has the lowest risk. Purchasing and holding these bonds are suitable for investors with moderate to conservative risk appetites. These are also ideal for an investment portfolio that leans toward wealth preservation rather than substantial accumulation. The following are the specific advantages of senior bonds:
• Priority in Liquidation: Senior bondholders have a higher priority in the liquidation process and are more likely to receive their principal and interest payments than other bondholders and even preferred and common stockholders. This makes senior bonds safer investments than other securities.
• Lower Overall Risks: These bonds also have lower credit or default risk than subordinated bonds and junior bonds. They also have lower liquidity risk because of their priority claim and due to the fact that the senior bond market is relatively large and more liquid than other sub-markets of the bond market.
• Investment Diversification: Purchasing and holding these bonds can provide diversification benefits. Having low-risk investments can counteract the impacts of high-risk investments and preserve the entire portfolio. Senior bonds can also supplement income generation from a specific fixed-income investment.
• Wealth Preservation: Another advantage of senior bonds is that investing in them can be part of a capital or wealth preservation strategy or a specific investment portfolio designed for preserving wealth. These are suitable for investors whose goals and objectives center on preservation rather than appreciation.
Cons: Disadvantages of Senior Bonds
Senior bonds follow the established principle of risk-return tradeoff. Hence, to be more specific, because these are low-risk investments, their returns are often lower than higher-risk investment options or vehicles. Purchasing and holding these bonds would not be ideal for individuals seeking to maximize their investments through optimal capital appreciation.
Furthermore, bonds still have risks, and senior bonds are not exempted from these potential drawbacks. Investing in these bonds does not make an investor immune to losses. Credit or default risk still exists. These bonds can also be impacted by changes in interest rates and inflation rates. The following are the specific disadvantages of senior bonds:
• Lower Potential Returns: The biggest disadvantage of senior bonds is that they have lower coupon rates and yields than junior bonds and subordinated bonds or other bonds such as short-term bonds and high-yield bonds. Investing in these securities might not be ideal for investors seeking higher returns.
• Unideal for Wealth Creation: Furthermore, because of their lower potential returns, purchasing and holding these bonds would not be suitable for those whose purpose in investing is to achieve significant capital appreciation or wealth creation regardless if the investment horizon is short-term or long-term.
• Specific Inflation Risk: The lower coupon rates of these bonds might not be ideal for beating inflation. Moreover, when inflation rises, the real value of coupon payments and principal might decline. This makes these bonds unsuitable for younger investors who would want to build their retirement funds while beating inflation.
• Note on Credit or Default Risk: It is important to underscore the fact that these bonds can still be exposed to credit or default risk. Repayment is not guaranteed because it is dependent on the financial standing and financial capabilities of their issuers. Other senior debts such as loans to banks also supersede senior bonds.